American companies are sending record amounts of cash back to shareholders, largely in the form of dividends.

NerdWallet looks at what’s driving this trend and dividend theory – when should a company issue a dividend, and if dividends are up, why are companies not reinvesting in their own growth?

The State of Play: Dividends Are Surging

Everybody likes dividends. It’s like everybody liking ice cream. But if your entire diet consists of all ice cream, all the time, it’s a sign that your diet is lacking enough substance and nutrition.

Now, the ice cream is getting scooped out for investors this year like it’s going out of style. A recovering economy and strengthening corporate profits have flushed corporate balance sheets with cash. A St. Louis Federal Reserve survey finds that publicly-traded corporations have accumulated $4.97 trillion in cash in 2010. Additionally, corporations are becoming more liquid; the amount of cash held as a percentage of corporate profits has doubled since the 1990s, from 6 to 12 percent.

This is true even though interest rates on savings were much greater in those days.

When Should A Company Issue A Dividend?

A firm should issue a dividend when management believes that their shareholders can get a better ROI by investing it themselves in the market. If the management team believes that they can get market-beating returns, then they should not issue a dividend (which is taxable, anyway), but they should reinvest that money in their own growth. If you’re a company chairman of the board of directors, and you haven’t been issuing a dividend, when would you want to start? Well, you would do so when you got to the point of diminishing returns – when you can no longer get market-beating returns from reinvesting in your own company, so you return the earnings to investors via dividends.

Dividend Theory: Comparing Options in 2013

2012 was a record year for total dividend dollars – and early indications are that 2013 will be even bigger. So what are companies doing with it – are they expanding? Are they hiring? No.

What can they do instead? In a nutshell, if a company takes in a dollar in profits, there are only a few things it can do with that money:

Pay down debts.

Buy back stock.

Reinvest it in the business, or in acquisitions, hoping to generate a market-beating return.

Stick it in cash and cash equivalents, just in case.

Return that money to investors in the form of dividends.

Option 1. doesn’t make as much sense as it used to. Interest rates are too low for investment-grade corporate borrowers these days. It’s cheap to borrow money.

Option 2 is pretty popular right now – in part because money is so cheap. It’s easy for companies to borrow money to buy back stock – especially to pay off executives executing stock options while the executing is good. But it shouldn’t be popular, with the S&P 500 once again trading within spitting distance of their all-time highs. The time to execute buybacks is when stock prices are low, not when they are high.

But think about what a corporation’s board of directors is telling you when they issue a dividend. They are saying, we have no confidence that we can reinvest this money back into the company at an acceptable rate of return, given the risks.

They are also sticking the investor with a tax bill of up to 39.6 percent, so be careful what you wish for.

Tax Implications

At the same time, corporations have been loath to bring any profits earned abroad home to the United States – and it’s getting worse. It’s not hard to see why. The second a C corporation brings money back to the United States, they will get smacked with a tax of 39.6 percent – up from 35 percent last year, and several times higher than many other developed countries, such as Ireland. That’s a powerful disincentive to repatriation – and a huge barrier to reinvestment within the United States.

The tax burden on this money is even more apparent when you consider the effects of double taxation. If a corporation wants to keep its earnings, bringing them home allows them to keep just $60.4 cents on the dollar, thanks to the high tax on corporate income. If they then issue a dividend with that money, the American investor may keep as little as $36.48 cents on the dollar. Corporations can’t write off dividends as an expense. The shareholder has to pay up to 36.9 percent tax on the 60.4 cents that’s left over. Hence the $36.48 number.

That’s before you even get to the 3.8 percent surtax that now applies on investment income, including dividend income, to higher-income individuals.

Let’s put that double taxation into perspective:

The image comes from the Tax Foundation. Congress postponed the tax hike, originally scheduled for 2010, for three years. But the new U.S. tax hikes are effective now.

What Signals Are Dividends Sending?

So keep this in mind when the Board of Directors of a company issues a dividend. They are, in effect, saying they believe their investors are better off with 40 to 60 cents on the dollar they earn than what they reasonably believe they can get by reinvesting the profits of the company back into the enterprise.

In fact, these people who are sending dividends back to shareholders in America, into the teeth of a confiscatory double-taxation regime, are also saying they can’t even think of companies they can usefully acquire. They would rather give half of the money to the government than use it to acquire assets with it.

You expect that once in a while, sure. You can also expect that from companies and funds that have a long-established dividend policy. That is, from enterprises that have specifically designed themselves to appeal to income-oriented investors, without regard to total return.

But when stock prices are high – as they are now, with the S&P punching through all-time highs – and the entire market pushing dividends going up as well, you have to approach things with caution.

If stocks are a great deal, then why is the surplus cash going to dividends, despite the tax bite, and not to asset purchases?

We’re seeing someM&A activity. In some circles, we’re seeing quite a bit of merger activity. But you also have to remember that debt is dirt-cheap. Bond prices are being held down by an aggressively expansionist Federal Reserve, artificially depressing the cost of money. That, in turn, takes a lot of the transactional costs out of a leveraged buyout. When QE3 runs dry, the tide will inevitably recede. When it does, one thing is going to become clear; financial assets are priced too high.

Disclaimer: The views and recommendations in this piece are held by the individual contributor and do not necessarily reflect the opinions of NerdWallet as a whole.

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